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Hartmarx Corp. and Subsidiaries v. Bower, No. 1-98-2309

1st District, December 23, 1999

SIXTH DIVISION

JUSTICE CAMPBELL delivered the opinion of the court:

Plaintiff Hartmarx Corporation and Subsidiaries (Hartmarx) appeals an order of the circuit court of Cook County affirming a decision by the Illinois Department of Revenue (Department). The Department ruled that sales shipped from Illinois by a member of Hartmarx's unitary business group to purchasers located outside Illinois should be "thrown back" to Illinois for inclusion in the numerator of the taxpayer's combined Illinois sales factor, where the taxpayer was not separately subject to tax in the destination State. The Department also assessed penalties for Hartmarx's failure to include such sales in its taxable income.

The record on appeal shows that Hartmarx is a Delaware corporation with its principal place of business in Illinois. Hartmarx is part of a unitary business group engaged in the apparel industry nationwide. The members of the unitary business group include (but are not limited to) Hart, Schaffner & Marx (HS&M) and Fashionaire Apparel, Inc. ("Fashionaire"). Section 502(e) of the Illinois Income Tax Act (Tax Act) provides in part as follows:

"(e) For taxable years ending on or after December 31, 1985, and before December 31, 1993, taxpayers that are corporations *** that are members of the same unitary business group may elect to be treated as one taxpayer for purposes of any original return, amended return which includes the same taxpayers of the unitary group which joined in the election to file the original return, extension, claim for refund, assessment, collection and payment and determination of the group's tax liability under this Act." 35 ILCS 5/502 (West 1996).

Hartmarx made this statutory election in each of the taxable years 1986-91.

In calculating corporate income tax pursuant to the Tax Act, an entity conducting business in more than one state uses a three-factor formula to determine what proportion of income is attributable to the various States. 35 ILCS 5/304(a) (West 1996). Specifically, the statute provides that:

"If a person other than a resident derives business income from this State and one or more other states, then, except as otherwise provided by this Section, such person's business income shall be apportioned to this State by multiplying the income by a fraction, the numerator of which is the sum of the property factor (if any), the payroll factor (if any) and 200% of the sales factor (if any), and the denominator of which is 4 reduced by the number of factors other than the sales factor which shall have a denominator of zero ***.

* * * * *

(3) Sales Factor.

(A) The sales factor is a fraction, the numerator of which is the total sales of the person in this State during the taxable year, and the denominator of which is the total sales of the person everywhere during the taxable year.

(B) Sales of tangible personal property are in this State if:

(i) The property is delivered or shipped to a purchaser, other than the United States government, within this State ***; or

(ii) The property is shipped from an office, store, warehouse, factory or other place of storage in this State and *** the person is not taxable in the state of the purchaser." 35 ILCS 5/304(a)(3)(A),(B) (West 1996).

Section 304 also provides in part as follows:

"(e) Combined apportionment. Where 2 or more persons are engaged in a unitary business ***, a part of which is conducted in this State by one or more members of the group, the business income attributable to this State by any such member or members shall be apportioned by means of the combined apportionment method." 35 ILCS 5/304(e) (West 1996).

During the tax years 1986-91, HS&M and Fashionaire sold goods shipped from Illinois to customers in states where HS&M and Fashionaire were not subject to taxation, but other members of the unitary business group were subject to taxation. Hartmarx did not include such sales in the numerator of the unitary business group's sales factor.

Following an audit of Hartmarx's books and records, the Department determined that Hartmarx improperly excluded the aforementioned sales from the numerator of the unitary business group's sales factor. The Department ruled that, under the "throwback rule" embodied in section 304(a)(3)(B), Illinois was authorized to include in the sales factor of the apportionment formula those sales of property shipped from Illinois to purchasers in States where that specific subsidiary was not taxable. Thus, the Department issued notices of deficiencies to the unitary business group for the tax years 1986-90, proposing assessments of $900,040 in tax and $102,820 in penalties. Hartmarx timely filed protests of these determinations.

Following a consolidated hearing on the protests, the administrative law judge (ALJ) recommended that the notices of deficiencies be affirmed, except that sales made by HS&M and Fashionaire to customers in States where the sellers were taxable would be excluded and that the penalty for tax year 1986 would be abated. The Director of the Department accepted the ALJ's recommendation.

Hartmarx then sought administrative review of the ruling, arguing that the throwback of these foreign destination sales was inappropriate, because other members of the unitary business group were taxable in those jurisdictions. The circuit court affirmed the Department, ruling that this court's decisions in Beatrice Companies, Inc. v. Whitley, 292 Ill. App. 3d 532, 685 N.E.2d 958 (1997), and Dover Corp. v. Department of Revenue, 271 Ill. App. 3d 700, 648 N.E.2d 1089 (1995), supported the Department's position. Hartmarx now appeals.

I

The standard for reviewing a final administrative decision is governed by the Administrative Review Law (735 ILCS 5/3-101 et seq. (West 1996)), which provides that our review extends to all questions of law and fact presented by the entire record. 735 ILCS 5/3-110 (West 1996). The factual determinations of an administrative agency are deemed prima facie true and correct. 735 ILCS 5/3-110 (West 1996). An agency's interpretation of the law it administers must be afforded substantial weight. Illinois Consolidated Telephone Co. v. Illinois Commerce Comm'n, 95 Ill. 2d 142, 152, 447 N.E.2d 295, 300 (1983). Courts recognize that agencies can make informed judgments upon the issues, based upon their experience and expertise. Illinois Consolidated Telephone Co., 95 Ill. 2d at 153, 447 N.E.2d at 300. However, an agency's conclusions of law ultimately are reviewed de novo. Envirite Corp. v. Illinois Environmental Protection Agency, 158 Ill. 2d 210, 214, 632 N.E.2d 1035, 1037 (1994).

II

The question on appeal is whether the Department properly applied the throwback rule to sales of goods by HS&M and Fashionaire that were shipped from Illinois to customers in other states where HS&M and Fashionaire were not subject to taxation, but where other members of the Hartmarx unitary business group were subject to taxation. When applied to a corporation, the term unitary business group describes a corporation with interrelated subsidiaries located in various States and countries. Subsidiaries in a unitary business group are so interdependent, however, that it becomes relatively impossible for one State to determine the net income generated by a particular subsidiary's activities within the State. Caterpillar Tractor Co. v. Lenckos, 84 Ill. 2d 102, 116, 417 N.E.2d 1343, 1351 (1981). The difficulty in determining the portion of income attributable to a particular State translates into difficulty in apportioning income for purposes of taxation. See Caterpillar, 84 Ill. 2d at 116, 417 N.E.2d at 1351.

The Uniform Division of Income for Tax Purposes Act (UDITPA), adopted in 1957 as a model act, sets forth guidelines for apportioning income when a business entity conducts business in different States. 7A U.L.A. 331 (1985). UDITPA was designed to enable States to apportion the income of a multistate corporation based upon the distribution of the corporation's property, sales, and payroll. UDITPA was incorporated into article IV of the Multistate Tax Compact (MTC), which became effective in Illinois in 1967. Caterpillar, 84 Ill. 2d at 118, 417 N.E.2d at 1352. The Illinois Income Tax Act became effective in August 1969. Caterpillar, 84 Ill. 2d at 117, 417 N.E.2d at 1351. Illinois withdrew from the Multistate Tax Commission and repealed the MTC in 1975, but an examination of various relevant provisions of UDITPA, the MTC, and the Illinois Income Tax Act shows that the language in each pertaining to the apportionment of business income is very similar and in some instances virtually identical. Caterpillar, 84 Ill. 2d at 120-21, 417 N.E.2d at 1353. Indeed, the official commentary on the Tax Act states that the rules for apportionment under sections 301 through 307 of the Act embody the principles underlying article IV of the MTC, which is UDITPA. Caterpillar, 84 Ill. 2d at 121, 417 N.E.2d at 1353.

Section 304 of the Tax Act follows UDITPA in providing that when an entity conducts business in more than one State, a three-factor formula (property, payroll and sales) is used to determine what proportion of income is attributable to the various States. Section 304 also provides that the business income attributable to this State by any member or members of a unitary business group partially conducting business in Illinois shall be apportioned by means of the combined apportionment method. 35 ILCS 5/304(e) (West 1996). The combined apportionment formula is calculated as follows:

"[T]o determine the apportionment factor for a group member subject to the Illinois income tax, the property, payroll, and sales factors would be computed using the individual group member's Illinois property, payroll, and sales as numerators, and the entire unitary group's property, payroll, and sales as denominators. The average of these three factors would be the group member's apportionment factor. This apportionment factor then would be applied to the group's total business income to derive the amount of business income on which the group member would pay Illinois income tax." General Telephone Co. of Illinois v. Johnson, 103 Ill. 2d 363, 371-72, 469 N.E.2d 1067, 1071 (1984).⁽¹⁾

The purpose of the combined apportionment formula is "to permit the fair determination of the portion of business income that is attributable to the business activity in Illinois by the reporting member of the unitary group." Caterpillar, 84 Ill. 2d at 121, 417 N.E.2d at 1353.

The throwback rule embodied in section 304(a)(3)(B) provides that sales of tangible personal property which occur in States where the group member is not taxable are deemed to be sales "in this State" and thus apportioned to Illinois. 35 ILCS 5/304(a)(3)(B) (West 1996). As the trial court noted in this case, this court has twice ruled that the Department properly applied the throwback rule to sales of goods by members of a unitary business group that were shipped from Illinois to customers in other states where those members of the group were not subject to taxation, but where other members of the unitary business group were subject to taxation in those destination States. Beatrice Companies, Inc., 292 Ill. App. 3d at 532, 685 N.E.2d at 958; Dover Corp., 271 Ill. App. 3d at 700, 648 N.E.2d at 1089. This court concluded that failure to apply the throwback rule in the manner advanced by the Department would result in a "nowhere" tax on the Illinois sales. Beatrice Companies, Inc., 292 Ill. App. 3d at 538, 685 N.E.2d at 962.

On appeal, Hartmarx contends that Dover and Beatrice are distinguishable because neither involved an interpretation of section 502(e) of the Tax Act, which permits the members of a unitary business group to elect to be treated as a single taxpayer. Given this argument, a brief recap of the history of this provision of the Tax Act may be useful.

In 1984, the legislature passed Public Act 83-1289, which provided in part as follows:

"For taxable years ending on or after December 31, 1985, and before December 31, 1993, taxpayers that are corporations (other than Subchapter S corporations) having the same taxable year and that are members of the same unitary business group may elect to be treated as one taxpayer for purposes of any original return, amended return which includes the same taxpayers of the unitary group which joined in the election to file the original return, extension, claim for refund, assessment, collection and payment of the sum of what would otherwise be their separate tax liabilities." P.A. 83-1289 (approved Aug. 31, 1984).

The Department proposed a regulation interpreting this legislation, which included an example indicating that a member of a unitary business group taxable in Illinois, but not taxable in the destination State of shipped goods, would not have sales to the destination State thrown back to Illinois.

However, before Public Act 83-1289 became effective, the legislature passed Public Act 84-221, which is incorporated in section 502(e) of the Act and provides in part as follows:

"For taxable years ending on or after December 31, 1985, and before December 31, 1993, taxpayers that are corporations (other than Subchapter S corporations) having the same taxable year and that are members of the same unitary business group may elect to be treated as one taxpayer for purposes of any original return, amended return which includes the same taxpayers of the unitary group which joined in the election to file the original return, extension, claim for refund, assessment, collection and payment and determination of the group's tax liability under this Act." See 35 ILCS 5/502(e) (West 1996).

The Department then proposed and promulgated regulations interpreting this legislation, which included an example showing that a member of a unitary business group taxable in Illinois, but not taxable in the destination State of shipped goods, would have sales to the destination State thrown back to Illinois. See 86 Ill. Adm. Code